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Working Paper: The Economic Consequences of Inequality

Was the long-term—and ongoing—rise in household income inequality a contributor to the recent financial crisis and subsequent recession? With support from the Russell Sage Foundation, Matthew Drennan, a visiting professor at UCLA, has released a working paper that argues that rising income inequality "was central to what has happened to relative consumption (the long-term rise of the Average Propensity to Consume), relative saving (the long-term decline in the saving rate), and consumer indebtedness." Here is an excerpt from the paper's introduction (posted with Drennan's permission):

What does the long rise of income inequality in the United States have to do with the Great Recession? The hypothesis of this paper is that there were two effects – one major and one minor. The major effect was that increasing consumer indebtedness, which supported consumption until the crash in 2008-09, was driven by the pressure to maintain consumption in the face of stagnant income for most households. That debt-supported expansion of consumption became unsustainable after 2007. As consumers have begun to reduce their debt and increase their saving, consumption will be depressed for some years, producing an anemic recovery. Consumer debt would have been much lower if income inequality had not increased so much, and the overhang of debt will weaken consumption growth for some years. The minor effect was that consumption during the Great Recession was somewhat less, and declined somewhat more, than it would have had income inequality not increased. Those hypothesized effects of rising income inequality have no place in the mainstream economic theories of consumption. To argue persuasively for those effects therefore requires showing that the mainstream consumption theories cannot explain recent trends in relative consumption and saving. Friedman’s permanent income theory of consumption does not explain the observed rise of debt-fueled consumption in the decade before the crash. Modigliani’s life cycle theory of consumption contains the seed of an explanation, but not one that he anticipated. Indeed, neither Friedman nor Modigliani posited any role for the distribution of income in their theories of consumption.

If we look further back in time, Malthus had the germ of an idea that excess saving, brought on by a top-heavy distribution of income, would curb effective demand and thus crimp the expansion of total output. But Malthus had no data, and his prose was less than lucid. But Keynes picked up on Malthus’ idea, which had lain dormant for a century thanks to the triumph of Ricardo’s general equilibrium perspective on the macro economy. Thus some of Malthus’ thinking on effective demand is echoed in Keynes’ General Theory. Keynes’ theory of consumption, fully developed in the General Theory and translated into algebra by his interpreters, dominated macroeconomics for many years. But Keynes’ theory inferred that the average propensity to consume (APC) would decline over time as incomes rose, curbing effective demand and perhaps leading to long-term stagnation. However, the post World War II data as well as Kuznet’s data going back to the 19th century, showed that inference to be wrong for the aggregate data. The APC did not decline; it was stable (mostly). Friedman argued that to be the case and so his theory of consumption infers a stable APC, not a declining APC. That infers a stable saving rate because (1-APC) = the saving rate. Modigliani’s consumption theory also inferred a stable APC because wealth and income in the long run would grow at the same rate. In large part because both Friedman’s and Modigliani’s theories fit the long term data while Keynes’ theory did not, their theories displaced the Keynesian theory of consumption. So the Keynesian notion that a more equal distribution of income would curb the fall of the APC disappeared, and income distribution no longer mattered for the theory of consumption.

Around 1985 however, something strange began. After a long period of stability, as hypothesized by Friedman and Modigliani, the APC began a long-term rise. That meant a longterm fall in the saving rate for the same period, an event not supposed to happen in Friedman’s theory. The rise in the APC was not supposed to happen in Keynes’ theory either. It was supposed to fall. Was the observed rise of the APC, 1984-2005, unprecedented? No. Kuznet’s 70 years of national income and consumption data shows a 30 year rise of the APC, 1909-1938, a rise Friedman overlooked when he cited Kuznets’ data in arguing for the long run stability of the APC. Kuznets’ data on income distribution, which begins in 1920 and ends in 1938, shows rising income inequality in the 1920s. We have no idea when that increase began. The fact that Kuznets’ long period of rising APC includes a decade of rising income inequality, and the 35 year rise of income inequality, 1974-2009 includes a long period of rising APC, raises the question of whether there is a causal link from rising income inequality to rising APC.

What is the theory that would explain such a link? Faced with slow or no income growth, households might resort to increased borrowing to maintain some desired level of consumption. The demand for borrowing can be curbed by interest rates and a hard income constraint. But the period from about 1995 to 2005, especially post 2000, can be characterized as a perfect storm of household indebtedness, fueled by four factors: (1) stagnant incomes for most households because of the long-term rise in income inequality, (2) unusually low interest rates after 2000, (3) legal and institutional changes that relaxed borrowing standards of lenders, raised the availability of credit, and made housing a more liquid asset, and (4) the housing price bubble.